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The use of shell corporations - When a franchisor’s shield becomes a third-party’s sword against the system’s franchisees

It is common practice for franchisors to insert shell corporations into certain aspects of their operations in order to safeguard their ultimate liability. That being said, the contracts used to set up such corporate structure must be carefully prepared in a manner that takes into account the franchisor’s entire system, as they may, in certain circumstances, end up increasing the franchisor’s liability. This was the unfortunate result in the recent Québec Court of Appeal decision of 9183-7708 Québec Inc. v. Soltron Realty Inc., rendered on January 29, 2016.

Facts

The franchisor in this case was Le Groupe Café Vienne 1998 Inc. (the Franchisor). Instead of leasing premises directly to franchisees, the Franchisor had an affiliated entity, Café Vienne Canada Inc. (the ShellCo), as the main tenant on all of the leases, which were rented from an independent third party, Soltron Realty Inc. (the Landlord). In turn, ShellCo subleased the premises to each of the franchisees through subleases. This was apparently done to maintain Franchisor control over the premises while shielding the Franchisor from any liability in the event of a franchisee’s non-payment of rent.

At some point, one of the franchisees stopped paying rent. The Landlord took action again ShellCo, as tenant under the main lease, and obtained a favourable judgment from the Superior Court of Québec. However, given that ShellCo had no assets, the judgment was unenforceable. The Landlord therefore applied for seizure by garnishment to obtain the rents directly from all subtenant franchisees in the network.

First instance judgment

At first instance, the judge relied heavily on the inadmissibility of the Franchisor’s corporate structure and granted the Landlord’s garnishment request vis-à-vis franchisees in the network at large. The judge refused to support what he referred to as a “stratagem,” that had the practical effect of nullifying the Franchisor’s liability, while at the same time giving the Franchisor control over the premises. This decision was problematic for the franchisor for two reasons. First, the decision was almost entirely based on the idea that franchisors cannot use corporate structures to both (i) shield their liability and (ii) maintain control over leased premises. Secondly, it allowed a third party to seize directly into the hands of other creditworthy franchisees the unpaid rent of one franchisee – which ultimately was negative for the whole franchise structure.

Court of Appeal

The first instance judgment was appealed both by the network franchisees and cross-appealed by the Landlord.

(i) Appeal

The franchisees claimed that the first instance judge had rendered a decision based solely on its distaste for the Franchisor’s commercial structure, and also argued that their rent could not be seized by garnishment given the legal mechanism of delegation of payment.

The franchisees’ appeal was successful on both points. Of importance, the Court of Appeal reaffirmed the right of commercial parties to arrange their affairs as they see fit, albeit within the parameters of the law:

[UNOFFICIAL TRANSLATION] In the absence of illegality, fraud or bad faith, and subject to particular provisions, value judgment on legal and commercial structures are not helpful in resolving the legal issues that they may raise. We must instead turn to law to find an answer to the issues raised by these structures.

(ii) Cross-appeal

The Landlord cross-appealed, inter alia, to obtain the royalties paid by the franchisees to the Franchisor. This cross-appeal was also granted by the Court of Appeal, who relied on certain cross-default language contained in the franchise agreement and in the sublease, who had been designed to protect the Franchisor.

Indeed, the Franchisor had its franchisees sign both the franchise agreement and the sublease which both contained cross-default clauses. Of particular importance, s. 12 of the sublease provided:

[UNOFFICIAL TRANSLATION] 12. It is agreed that all the terms, obligations, conditions, provisions, rights and remedies provided in the Main Lease and the Franchise Agreement shall apply mutatis mutandis to this Sublease. In addition, it is agreed that all amounts due under the Franchise Agreement are deemed to be the rent under this Sublease and may be claimed under this Sublease.

The Court of Appeal concluded that this provision gave ShellCo the right to demand that the franchisees pay, as rent, any and all amounts due to the Franchisor. This included royalties due under the franchise contract. In turn, according to the Court of Appeal, Landlord could force ShellCo to demand these amounts from the franchisees in order to execute the judgment rendered against it.

In other words, the Franchisor sought to protect itself by having an affiliate shell entity act as tenant. In doing so, the Franchisor prepared a set of contracts that contained cross-default clauses which allowed ShellCo to request, as rent, payments due under the franchise contract. In turn, a third party such as the Landlord was able to use that cross-default clause to its advantage and force ShellCo to obtain from the franchisees any amounts due to the Franchisor under the franchise contract, such as royalties, to execute the judgment it had obtained.

Practical implications

While relatively complex, this decision sets out a number of key elements for franchisors to consider:

Franchisors are allowed to safeguard their ultimate liability by using shell corporations, within the parameters of the law.

In leasing matters, this strategy may be useful to avoid liability for non-payment of rent by the franchisees.

However, franchisors must be particularly careful not to give their shell corporation the power to demand payments that belong to the franchisors, as this may be used by a third party to execute on judgment against the shell corporation.

Compare jurisdictions: Arbitration

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